LONDON, Jan 12 (Reuters) - The euro surged above $1.21 to a three-year high Friday on bets the European Central Bank is getting ready to wind down its huge monetary stimulus, and after German Chancellor Angela Merkel reached a deal that should lead to the formation of a “grand coalition” government.

The single currency had already rallied on Thursday, after ECB policymakers said in minutes of the bank’s December meeting that they could revisit their communication stance in early 2018.

It added to those gains on Friday, rising 0.8 percent to as high as $1.2137, its strongest since Dec. 31, 2014, after Merkel’s conservatives and the Social Democrats agreed to a blueprint for formal coalition negotiations, raising prospects of an end to months of political uncertainty in Europe’s biggest economy.

But anaylsts said the main driver for the euro was still the ECB minutes.

“Clearly a grand coalition is more euro-friendly than the three-party government that was under discussion right after the election, but that was already clear so I don’t see any new developments there,” said Commerzbank currency strategist Esther Reichelt, in Frankfurt.

“The dominant factor for the euro is the ECB,” she added.

The euro was on track for a more than 1.5 percent rise since Thursday - its strongest two-day performance since August.

“The sooner the market realises that the end of ECB tapering is coming, it will start asking itself what the next step is, and that’s ECB rate hikes. That’s not priced in yet,” said ING currency strategist Petr Krpata in London. The bank sees the euro at $1.30 by the end of the year.

Hedge funds kicked off 2018 with their biggest bet ever on the euro rising, data showed last week.

Hit by the strong euro, the dollar index - which measures the U.S. currency against a basket of six major rivals - slipped 0.6 percent to its weakest in four months, at 91.308.

The dollar was also pressured by data on Thursday that showed U.S. producer prices fell for the first time in nearly 1-1/2 years in December, which could temper expectations that inflation will accelerate in 2018.

Against the yen, the dollar hit a six-week low of 111.00 yen .

It was still down a steep 1.7 percent for the week, with the Japanese currency having soared as a routine operational reduction in bond purchases by the Bank of Japan triggered speculation that the central bank would unwind its massive stimulus.

“Yen short positions had been building, and investors seem to be looking for opportunities to trim them,” said Yutaka Miura, a senior technical analyst at Mizuho Securities.

Bitcoin was up 1.8 percent at $13,485 on the Luxembourg-based Bitstamp exchange. It skidded over 11 percent in the previous session after the government of South Korea, a crucial source of global demand for cryptocurrency, said it was considering a plan to ban cryptocurrency trading.